Stock options provide an excellent opportunity to earn additional income beyond your salary (or fees for your services), and to acquire an ownership interest in our company. To make the best use of this benefit, you need to understand the complex legal and tax provisions surrounding those options.
This Q&A memo is not intended to provide a comprehensive analysis of any particular tax situation, nor should it be substituted for expert advice from a personal tax or financial advisor. We strongly encourage you to consult a tax advisor before exercising your option or disposing of option shares.
There is always a possibility that the tax laws affecting stock option tax treatment will change. The procedures explained in this guide are also subject to change at our discretion.
1. What is a stock option?
An option is granted under a stock option plan. A stock option is a contract that gives you the right to purchase a specific number of shares of stock at a fixed price. Your purchase price ("exercise price") is based on the value of
the stock on the day your option is granted (which is the day the Board of Directors
approves your option grant). You may exercise this right at certain times over a period of years (the option "term").
2. Why is my stock option valuable?
Your option is valuable because it gives you the right to purchase a company's shares at a fixed exercise price over the term of your option. You are not under any obligation to exercise your option. As a result, if
the company's stock increases in value after your option is granted, the value of your option increases as well since you are able to purchase
the company's shares at the lower exercise price. However, if the company's
stock declines in value after your option is granted, so long as you have not exercised your option, you have not suffered a loss.
3. How are options granted?
Only the Board, or a Board committee, can grant stock options. Both federal and state laws govern
a company's right to sell stock to employees, directors and consultants.
A company may grant incentive stock options ("ISOs") only to employees, but
a company may grant nonstatutory stock options ("NSOs") to employees, directors and consultants.
The general terms and conditions of stock option grants are set out in a plan document. The specific contract between you and a company is the grant notice and its attached stock option agreement, which reflect the terms and conditions of your option. After the Board grants your option, you will receive your grant notice and stock option agreement, which will define the exact terms of your option, listing the number of shares and the price per share.
4. Why do you grant options?
Companies reward, motivate and retain valued employees, directors and consultants in many ways, one of which is granting stock options. Progressive
companies encourage their employees, directors and consultants to participate in their success by awarding stock options.
5. How is my exercise price determined?
Legal, tax and accounting restrictions generally require that the company sets your exercise price at not less than the "fair market value" of
the stock on the day the option is granted.
6. What Does the Term "Fair Market Value" Mean?
"Fair market value" of a stock is the price that a reasonable person could be expected to pay for
the stock. A private company makes a good faith determination of fair market value at the time of option grant based on such factors as performance, recent stock sales, and economic conditions generally. When a company's shares are traded publicly, on the other hand, the fair market value is determined by looking at the quoted price or the most recent purchase or sale price.
7. What does the term "exercise" mean?
When you exercise your option, you purchase stock from the company at your exercise price. You may pay for
the stock with one or more of the forms of payment permitted under the terms of your option.
8. What does the term "vesting" mean?
Vesting refers to the process of your option becoming free from a company's contractual right to reacquire any stock that you purchase by exercising your option and is typically tied to your continued service to
the company. Thus, as your option vests, you may (but do not have to) exercise the vested portion of your option. Any vested stock you purchase will be free of
the company's reacquisition right. If the terms of your option permit this, you also may purchase stock that has not yet vested. However, if your service ends before all
the stock is vested, the company may reacquire any unvested shares of stock, generally at the price you paid (your exercise price), without interest.
9. Must I buy the shares when they vest?
No. You may exercise your option at any time before your option expires. Generally, your option expires at the end of 10 years or if earlier a specified time after your service ends.
When you decide to exercise your option, you may purchase all or any portion of the vested shares and, if your option permits "early exercise," the unvested shares as well. If your service ends before all of our stock you purchased is vested, then, depending upon the terms of your option, the company may reacquire your unvested shares. Generally you will receive back your original purchase price rather than the fair market value of the shares.
10. What is the effective date of exercise?
The effective date of option exercise is the date that we receive all required forms and payment of the exercise price from you.
11. When are stock certificates issued?
Stock certificates are generally issued within three or four weeks after you exercise your option.
12. The terms of my option permit me to exercise the unvested portion of my option. Since you may repurchase my unvested shares, why would I want to early
exercise at all?
You may want to early exercise your option and acquire unvested shares for tax reasons. Increases in the fair market value of our stock after the date of exercise are eligible for taxation at capital gain tax rates (currently a maximum federal rate of 20% for long-term capital gains if you
hold the stock for more than one year). Generally any appreciation in the fair market value prior to the date of exercise ends up being taxed at ordinary income tax rates (currently a maximum federal rate of 39.6%). In addition, if you hold
the stock for at least five years after the date of exercise and if we satisfy a variety of conditions, we will be treated as a "qualified small business." As a result, if the fair market value of our stock increases after you exercise your option, the maximum federal income tax rate for such increase could be as low as 14%.
The federal tax law in this area is complicated and technical. In addition, your specific tax consequences will be affected by how your option is characterized for tax purposes as well as by how you handle your option and any shares of our stock you acquire upon exercising your option. Further information is provided below in the section labeled "Taxes."
13. I understand that the company's stock may be publicly traded at some point. If this happens, the trading price of
the stock is likely to be substantially higher than my exercise price. How might this affect the exercise of my option?
Your ultimate decision whether or not to exercise your option depends on your evaluation of the risk of putting up capital currently for
the stock, which may increase, decrease, or stay the same in value. You must weigh this risk against your potential additional tax cost of exercising later if the value of our stock increases. Factors that will affect your decision may include the following:
* Whether you plan to retain the stock for a significant period of time after exercising your option.
* Whether your option is an ISO or an NSO.
* If your option is an ISO, whether you are potentially subject to the alternative minimum tax.
Generally if your option is an NSO and if you plan to retain the stock for a significant period of time, even after an initial public offering, then it would probably be advisable to exercise before the IPO.
If you do not plan to hold on to the stock, then you must balance the risk of putting up the exercise price now against the potential savings of capital gain treatment, if applicable, at the time of disposition. If your option is an ISO, the analysis is similar to the analysis for NSOs except that, to the extent that you could exercise your ISO in the future without incurring any alternative minimum tax, your advantages of exercising early are reduced.
NSOs - If the value of the stock increases. Your alternative to exercising your option today is to hold it for possible exercise until some later date. For purposes of this comparison, assume that you would either exercise today (the "early exercise date") or exercise after an IPO, or if
the company never goes public, on the last day your option remains exercisable (the "late exercise date"). Your economic advantage of waiting until the late exercise date, disregarding tax consequences, is to allow you to invest the exercise price of your option elsewhere during the entire period until exercise, without losing any of the investment potential of your option. In addition, you avoid the risk of loss from stock ownership until exercise.
Your tax disadvantage of exercising on the late exercise date is that you will become subject to tax at the time of exercise. You will be taxed on the difference (the "spread") between the fair market value of the stock at the time of exercise and the exercise price at the rate applicable to ordinary income. If you believe that the value of our stock will appreciate significantly in the future, you may want to consider exercising your option now to minimize the spread that would be subject to ordinary income tax rates.
If you sell the stock soon after exercising on the late exercise date (and assuming no change in fair market value between exercise and sale), then there will be no additional tax. However, assume that you exercised at the early exercise date and sold shortly after the late exercise date and after holding the stock for more than one year. In that case, there would be a tax at the time of sale on any gain (which is the difference between the sale price and the fair market value of the stock on the early exercise date) at the long-term capital gains rate.
As discussed above, your net long-term capital gain, if you are currently subject to a maximum marginal federal income tax rate, is 20% (and 14% if the stock satisfies the requirements for "qualified small business stock" and you have held the stock for more than five years). Contrast this rate to the maximum marginal federal rate for ordinary income of 39.6%.
NSOs - If the value of the stock does not increase. If you exercise an NSO at the early exercise date, you must pay tax on the spread at that time and lose the use of the capital required to exercise and pay the tax for the entire period that you hold our stock. In addition, your capital is now subject to the risk that the stock price will fall. If instead of exercising today, assume that you hold your option and exercise it on the late exercise date. If the value of the stock does not increase before such time, then you will have retained the use of the capital that you otherwise would have used to exercise your option and pay the tax today until such late exercise date. In addition, if the price drops below the exercise price, you will avoid a potential loss.
ISOs. ISOs are subject to similar considerations. There are some differences, however, which are outlined below.
The exercise of an ISO is not generally a taxable event. However, you generally will include the spread at the time of exercise in your income for purposes of computing your alternative minimum taxable income. This may result in your being subject to alternative minimum tax. If you are not subject to alternative minimum tax at the time of exercise, then there will generally be no adverse tax consequences if you exercise your ISO. However, the ISO two-year and one-year holding periods (discussed below) will start. Your satisfaction of these holding periods could provide you with more favorable tax treatment. Thus, there is frequently little reason to exercise early in such a situation, unless by delaying exercise the spread increases enough to subject you to alternative minimum tax at the time of
exercise.
If you are subject to the alternative minimum tax at the time of exercise, then the analysis is similar to the NSO analysis with several differences:
* Your federal income tax will be at capital gain rates at the time of disposition on the full amount of any gain or spread if you dispose of
the stock in a qualifying disposition. A "qualifying disposition" means that you held
the stock for at least two years after the date of your option's grant and at least one year after the date of exercise.
* Alternative minimum tax takes a lesser tax bite than the maximum tax rate on ordinary income of 39.6% (see the discussion of the alternative minimum tax below).
* Any alternative minimum tax you pay by reason of exercising your ISO is available as a credit against your regular tax in future years.
For purposes of this comparison, the exercise of an ISO or NSO and immediate disposition of the stock would be subject to essentially the same tax treatment.
Conclusion. It may be that you expect to retain the stock for at least one year beyond your exercise date and you expect the value of the stock to appreciate significantly in the future. In that case, it may be advisable for you to exercise your option in the near future to minimize the amount of spread that would be subject to ordinary income tax, or alternative minimum tax in the case of an ISO. One caveat. If your option is an ISO and you do not expect to be subject to alternative minimum tax in the year of exercise, then you might consider waiting to exercise your option.
If you intend to dispose of your stock within a short period after your exercise date, then you should carefully consider the following:
* the relative values of any tax benefit of current exercise,
* the economic benefit of retaining the exercise price, and
* the benefit of avoiding any loss
in light of how much you expect the value of our stock to increase. If you do not expect the value of our stock to increase in the near future, delayed exercise may be advisable, depending on the expected appreciation in the value of our stock.2
14. Can I sell my stock right away?
Generally, no. Since there is no public market for the stock, you may sell it only in private sales that comply with all applicable securities laws, as concurred in by
the company's legal counsel. However, it may be very difficult to comply with these securities laws, and you should keep in mind that there never may be a public market for your shares.
15. When can I actually sell my shares? What impact does an IPO have on my ability to sell?
All shares of the stock you acquire prior to an IPO constitute restricted securities under the federal securities laws. Rules 144 and 701 under the Securities Act of 1933 permit holders of restricted securities to sell those shares in the open market, provided that the numerous conditions of such rules are met. However, you should expect that any shares that are "restricted securities" are not readily or easily salable to anyone prior to the time that our stock has been publicly traded for approximately six months.
(Note: Shares that are registered with the Securities and Exchange Commission and are sold as part of an IPO do not need to comply with these requirements. However, any of the company's officers, directors or major shareholders who wish to sell some of their holdings need to ensure that such a sale does not trigger a violation of the short-swing trading profits liability provisions of Section 16(b) of the Securities Exchange Act of 1934.)
In addition, your option contains a "lock-up agreement." This agreement prevents you from selling
the stock acquired upon exercise for a period of up to 150 days following an underwritten public offering of our stock without the prior written approval of the underwriters. Stop transfer instructions will be placed with the transfer agent on shares held by persons who are bound by lock-up arrangements.
Taxes
16. What is the difference between an ISO and an NSO?
ISOs are eligible for more favorable tax treatment than NSOs, in part because your tax is deferred until you sell or otherwise dispose of our shares. NSOs are taxed differently. You will be taxed upon your exercise of an NSO. However, there is a difference in the amount of tax, depending upon whether
the company's shares are vested or unvested. Upon exercise of an NSO to purchase vested shares, you are taxed on the difference between your exercise price and the fair market value of
the stock on the date of exercise. Upon exercise of an NSO to purchase unvested stock, on the other hand, you are taxed differently. You are taxed on the difference between your exercise price and the fair market value of
the stock on the date that the stock vests (unless you elect -- known as a "Section 83(b) election" -- to calculate your taxable income on the date of exercise). The law requires us to withhold income and employment taxes on any taxable income recognized relating to an NSO if you are an employee.
17. I understand that I cannot be granted ISOs that are first exercisable for more than $100,000 per year. How does this limit work?
This is a complicated area. The federal tax laws restrict the company's ability to grant ISOs under certain circumstances, as follows:
If the aggregate fair market value of the shares under all ISOs that you hold that were granted by the company and that are exercisable for the first time during a particular calendar year is greater than $100,000, then those shares with a value over $100,000 will be treated as NSOs. This rule is applied by taking options into account in the order in which they were granted.
Note, the test is when your option is first exercisable, not when you actually exercise your option. Therefore, the need to break down your option into an ISO and a NSO portion can be determined when your option is granted. Keep in mind that your option is more likely to violate the $100,000 per year limitation if it has an early exercise feature (that is, it is immediately exercisable in full) than if it is exercisable as it vests over a period of years because, in the former case, all of the shares are first exercisable on the date of grant. The $100,000 per year limitation also can be an issue if the exercisability of your option is accelerated, for example, on a change in control because all of the then unvested shares become first exercisable at the same time.
Following are examples of the application of the $100,000 per year limitation. The examples assume that you are granted an option this year for 150,000 shares with an exercise price of $1 per share (total $150,000 value):
* If your option is immediately exercisable and no other ISO is first exercisable (in whole or in part) this year, then 100,000 shares are ISO shares, and the remaining 50,000 shares are NSO shares.
* If your option is immediately exercisable but 50,000 shares of an option granted to you last year will vest and become exercisable for the first time this year at $1 per share, then only 50,000 shares of your current option are ISO shares and the remaining 100,000 shares are NSO shares.
* If your option is not immediately exercisable but, rather, vests and is exercisable at the rate of 50,000 shares per year, starting next year and you have no other ISO outstanding, then all 150,000 shares are ISO shares.
18. What taxes are due upon exercise of an NSO?
With an NSO you typically recognize taxable income upon exercise. In general, the difference between the fair market value of
the stock on the date of purchase and the exercise price (the "bargain element") is taxable income on the date of purchase. Under an NSO, this bargain element is treated as compensation income and taxed just like salary or a fee for services. As a result, if you are an employee, you will be required to pay
the company an amount sufficient to meet the withholding tax triggered by the NSO exercise.
As noted above, if you acquire unvested stock, the rules are the same as just described, except that the date on which taxable income is calculated is the date the stock vests (unless you make a Section 83(b) election to calculate taxable income on the date of exercise).
19. How are ISOs treated more favorably than NSOs?
Under current tax rules, the bargain element described above is not taxed at the time of exercise or later vesting (unless you are subject to the "alternative minimum tax" described below). Instead, you do not incur taxable income in connection with your ISO until you sell or otherwise dispose of
the shares. In addition to this deferral of tax, if you meet the holding periods described below, the bargain element will be capital gain rather than ordinary income. The difference between the exercise price and the sale price will be treated as a long-term capital gain or loss. Currently, long-term capital gains enjoy preferential capital gains rate (generally a maximum rate of
20%). Capital gains may be offset by capital losses.
20. Example
Assume that Eve Jones was granted an option on January 1 to purchase 40,000 shares. She is now purchasing 10,000 fully vested shares at $0.125 per share or a total exercise price of $1,250. When she exercises the option (when she purchases the 10,000 shares), our stock has a fair market value of $0.90 per share, or $9,000. Because she had to pay only $1,250 for shares worth $9,000, Eve has a $7,750 bargain element. She theoretically has made $7,750 simply by exercising her option.
If the option Eve exercised was an NSO and our shares were fully vested, she would owe taxes on the $7,750 as though it had been paid to her as salary or a fee for services.
If the option were an ISO, Eve would be entitled to defer payment of taxes on the $7,750 bargain element until she sold or disposed of our shares (unless she owed alternative minimum tax, as explained above). If Eve sells our shares for $2 per share, or $20,000 after meeting the ISO holding period requirements, she would recognize taxable income in the year of sale only on $18,750 at long-term capital gain rates (generally a maximum of 20%).
21. What is the alternative minimum tax ("AMT")?
If you exercise an ISO, the bargain element is included in the computation of your alternative minimum tax liability, if any. In general, the concept of a "minimum tax" grew out of a concern that the tax laws permitted some individuals with large incomes to pay little or no tax, while other individuals with far less income were required to pay a higher percentage of their income in tax. As a result, the minimum tax was introduced to assure that taxpayers with substantial tax-exempt or tax-deferred income would have to pay some minimum amount of tax. Since the bargain element realized in connection with the exercise of your ISO is included in this minimum tax calculation, you may or may not trigger alternative minimum tax liability upon ISO exercise, depending upon your particular situation.
Your AMT for a tax year is the excess of your tentative minimum tax over your regular tax. For example, if your tentative minimum tax is $75,000 while your regular tax is $50,000, you must pay an AMT of $25,000 in addition to your $50,000 regular tax.
Your tentative minimum tax is initially determined as the sum of 26% of the first $175,000 (or $87,500, in the case of married taxpayers filing separately) of alternative minimum tax income ("AMTI") in excess of the applicable exemption amount. Your tentative minimum tax is 28% of any additional AMTI, in tax years ending before May 7, 1997. In tax years ending after May 6, 1997, the 26%/28% rates are lower. Special transitional rules apply in tax years that include May 7, 1997, and slightly lower rates may apply in tax years beginning after December 31, 2000.
The AMT takes into account what are called tax preference items and other adjustments that are not taken into account when calculating taxes in the regular manner. One of the adjustments is the inclusion in AMTI of the "spread" of an ISO; that is, the difference between the exercise price of the ISO and the value of the stock on the exercise date, if that amount constitutes a profit. If you pay AMT upon exercise of an ISO, you are entitled to a credit against regular tax (but not AMT) in later years. When you sell the stock, you are allowed, for purposes of calculating your AMT in the year of sale, to decrease the profit by the adjustment amount previously included in your AMTI in the year of exercise.
If you are subject to a risk for forfeiture, the amount of the adjustment will be calculated using values on the dates the forfeiture lapses rather than the date you exercise your option, and the adjustment must be made in the year in which the risk of forfeiture disappears. (For example, unvested shares are subject to a risk of forfeiture if you early exercise your option.) You may be able, however, to make a Section 83(b) election within 30 days of your exercise date. If you make a valid election, our stock value on the exercise date will be the price you use in calculating your AMT and in making the adjustment in the year of exercise. However, if you make a Section 83(b) election, there may be implications for purposes of calculating ordinary income, if any, if there is a disqualifying disposition of your ISO shares.
22. What are the ISO holding periods?
To avoid a "disqualifying disposition," you must not dispose of the shares you purchased in an ISO exercise within either:
* 1 year from the date of option exercise, or
* 2 years from the date of option grant.
23. What is a disqualifying disposition?
A "disqualifying disposition" is the sale or disposition (including by way of gift) of ISO shares before the end of the holding periods. Upon a disqualifying disposition of ISO shares vested on the date of exercise, you recognize taxable income at that time measured as the difference between the fair market value of
the shares on the date you exercise your option and your exercise price. However, if
the shares decline in value after you purchase them, your taxable income triggered by a disqualifying disposition will be limited to the excess, if any, of the difference between the sales price and your exercise price. If you make a disqualifying disposition, you must notify us. If you are an employee, we will include the taxable income on your W-2 Form for the year in which the disqualifying disposition occurs, although withholding is not currently
required.
EXAMPLES OF INCENTIVE STOCK OPTION TAX TREATMENT
ASSUMPTIONS USED IN EXAMPLES
OPTION granted on January 1
40,000 shares at $0.125/share
Exercise/Vesting Schedule
10,000 One year later
10,000 Two years later
10,000 Three years later
10,000 Four years later
(a) Exercise Price: $0.125
(b) Fair market value at exercise: $0.90
("FMV")
(c) Sale Price: $2.00
(d) Bargain Element $0.775 (FMV minus exercise price)
(e) Gain between exercise & sale $1.10 (sale price minus FMV)
(f) Proceeds from sale $1.875 (sale price minus exercise price)
EXAMPLE 1: ISO exercised and held for required ISO holding periods (2 years from date of grant and one year from date of exercise). This is not a disqualifying disposition and, therefore, the total income is capital gain because the shares were sold both more than 2 years after grant and more than 1 year after purchase. The capital gain is long-term capital gain because the shares were held for more than 12 months, after purchase.
10,000 shares @ $1,250
Grant Date: January 1
Vest Date: 12 months after grant date (January 1)
Purchase Date: 24 months after grant date (January 1)
Date Stock Sold: 13 months after purchase date (April 1)
Taxable Income: 10,000 x $1.875 =$18,750 long-term capital gain.
EXAMPLE 2: A disqualifying disposition within the same calendar year as the purchase date (no alternative minimum tax calculation required).
10,000 shares @ $1,250
Grant Date: January 1
Vest Date: 12 months after grant date (January 1)
Purchase Date: 18 months after grant date (July 1)
Date Stock Sold: 5 months after purchase date (December 1)
Taxable Income: 10,000 x $.775 = $7,750 ordinary income.
10,000 x $1.10 = $11,000 short-term capital gain
* The bargain element is ordinary income because the shares were sold 18 months after grant and 5 months after purchase, which is both within 2 years from grant and within 1 year from purchase (a disqualifying disposition on two bases).
* The additional gain is short-term capital gain because the shares were held only 6 months after the purchase date, which is not more than 1 year.
* The alternative minimum tax does not apply in the year of purchase because the purchase and sale occurred in the same taxable year.
EXAMPLE 3: A disqualifying disposition in a calendar year subsequent to the purchase date (alternative minimum tax calculation required in year that shares are purchased).
10,000 shares @ $1,250
Grant Date: January 1
Vest Date: 12 months after grant date (January 1)
Purchase Date: 18 months after grant date (July 1)
Date Stock Sold: 6 months after purchase date (January 1)
Taxable Income: 10,000 x $.775 = $7,750 ordinary income
10,000 x $1.10 = $11,000 short-term capital gain
* The bargain element is ordinary income because, although the shares were sold 24 months after grant, the sale occurred only 6 months after purchase, which is not within 1 year from the purchase date (a disqualifying disposition on one basis).
* Additional gain is short-term capital gain because the shares were held for only 6 months, which is not more than 1 year from purchase.
* The alternative minimum tax applies in the year of purchase because the purchase and sale did not occur in the same taxable year.